If you step back and look at the gold market, it really isn't too complicated. Dig up some yellow metal and sell it. How much you make depends on your mining costs and the current price of gold in the spot market or the price you've locked in with hedges. But nothing is ever that simple, which is why gold market investors should take a deeper dive to make sure they understand the nuances of a market that's far more complex than it at first seems.
No more picks and shovels
The iconic images of gold mining are an old, bearded man with a pick ax guardedly protecting his claim, or, perhaps, a man bent over a river with a gold pan. Those pictures may have been true way back in the California gold rush days, but they certainly aren't true today. Gold mining is big business, with heavy machines doing most of the work. And that's one important thing you need to understand about gold, it's actually pretty hard to get at.
First things first: You actually have to find gold. That means geologic surveys and testing. The goal is to figure out not only if there's gold present at a potential mine site, but also if there's enough of it to justify spending the money to build a new mine or expand an existing one. Mines are costly to construct and don't produce any revenue until they're up and running, which can be years away from when a project first breaks ground. That generally means taking on debt to fund new projects, which is a big financial risk that miners don't take lightly.
The other option is to buy an existing mine. But that's not easy, either. You still have to do the testing and analysis to make sure what you're buying is what you think you're buying. The price of the investment will depend greatly on how much gold you think you can profitably get out of the ground and what you think future gold prices will be.
And here's the rub: Miners always have to be on the lookout for new gold reserves. That's because as they pull gold from the ground they are depleting the amount of gold they can mine in the future. If they don't add more reserves to replace the gold they mine they will quickly mine themselves out of business. So the search for gold is an ongoing cost.
I found gold ... now what?
So let's assume you've found gold. Now what? You can't just start digging holes. That's true for many reasons, but one of the most important is that gold mining is highly regulated. You need to make sure what you want to do is approved by all of the appropriate regulatory bodies, which often means dealing with fickle foreign governments. That can be a headache in the best cases and a nightmare in the worst.
You also have to get the image out of your head of big gold nuggets just lying around waiting to be found. The gold market just doesn't operate like that anymore. Today it's science that leads the pack. As an example, giant global gold miner Newmont Mining Corp. (NYSE:NEM) uses techniques such as milling, heap leaching, flotation plants, and bio-milling to extract gold from its mines. Don't worry if that sounds like gibberish -- you'd have to be in the industry to really understand each of those processes.
But to give you an idea, milling is probably the easiest to understand. Basically, "the ore is ground into a fine powder and mixed with water into a slurry." So far, so good. The slurry then "passes through a carbon-in-leach circuit." A carbon-in-what? OK, so milling isn't all that easy to understand, but essentially, a chemical process is used to get the gold to attach itself to carbon so it can be easily isolated in a later stage of the milling extraction process. The other processes noted can be even more complex.
But with complexity comes added cost. So the processes a miner needs to use to get at the gold it's trying to find can have a big impact on its cost structure. And that's really important, because gold is a commodity market. In flush times, when gold prices are high, costs are less of an issue. But when gold prices are low, keeping costs in check can be the difference between a profit and a loss.
Each mine, then, will have its own cost structure, and some will simply be better than others. Newmont, for example, has some mines with all-in sustaining costs -- a gold market measure of how much it costs to get an ounce of gold out of the ground -- of as low as $600 an ounce. But it has other mines with costs in the $1,100-an-ounce range. That's a huge difference, making costs a key issue to watch.
We aren't done yet
So we've found gold and pulled it out of the ground using some high-tech science. Now we sell it, right? Yes, but, once again, it isn't that easy. One ounce of gold is pretty much the same as any another ounce of gold, so it's a commodity. That means supply and demand will dictate the price a miner gets. But who, exactly, is setting that price?
The answer is multifaceted. Gold is a store of wealth, so countries around the world own a lot of the stuff. While countries are often large buyers, they can also turn around and sell their gold reserves, putting downward pressure on prices. If you're watching the gold market, you'll want to keep an eye on what countries are doing with their gold stockpiles.
Gold as a store of wealth is also why many individuals buy gold. Most of these so-called gold bugs don't buy or sell enough gold to materially affect the broader gold market, but that doesn't mean this group isn't important. And then there are coin collectors, or numismatists, who buy coins and medals that have value beyond the price of gold. Again, not a huge impact on the broader gold market, but something to be aware of.
Gold is also used in jewelry, which I bet you already knew. It's a pretty large market you'll want to keep an eye on. However, while gold demand from gold bugs may go up when economic weak spot show up, jewelry demand tends to fall during weak patches -- a dynamic that's important to remember. High gold prices, as you might expect, can also depress jewelry demand.
Looking at gold from a more scientific point of view, it has properties that make it useful in the industrial and technology spaces. You may have some in your mouth (gold is malleable and largely non-reactive) or whatever electronic gadget you're using to read this (gold is an excellent conductor of electricity). So these are additional end-markets to watch.
The market for gold is far more complex than it at first appears. And there are lots of forces driving the day to day price of the metal. So even though you can boil it all down to supply and demand, there's more going on behind the scenes. You'll want to understand some of the nuances.
But we aren't done just yet. We've found gold, pulled it out of the ground and readied it for sale, sold it, and ... now what? Remember gold mines have limited life spans. Once you pull all of the economically recoverable gold out of the ground, you just have an empty pit. Gold mining is a highly regulated market, so simply walking away from a spent mine isn't an option.
That's why gold miners put away money each year for what's called reclamation costs. That's essentially what the miner believes it will cost to return the mine back to what it looked like before mining began. And while the cost of this process is accrued over time, the actual work still has to be done. So even after a mine is no longer producing gold, a gold miner's job isn't done.
And now you understand the gold market
Finally, we've tracked a gold mine and what it produces from beginning to end. So now you can see why the gold market is really far more complex than it at first appears. It's isn't that you need to know how to use bio-milling or how to turn gold into a dental filling, but you do need to understand these things to have a better picture of what a gold miner you may own is really up against.
And now that you have a grasp on the basics of the gold market, the industry's ups and downs should make more sense to you. And, perhaps more important, you should also be able to make more informed investment decisions.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.